Utilities are running in to Interest Rate Resistance

by Wayne Ferbert on June 3rd, 2013

We have been fans of the Utility sector for the better part of the past year: not so much for your equity allocation but instead as a fixed income replacement. It has had an attractive yield relative to the fixed income market.
 
The XLU is the SPDR ETF that covers that sector exposure in the S&P500.  The sector had an excellent run up to the end of April hitting real nice highs. But May was a tough month. It was down 9% in the month of May alone.
 
The culprit? Rising interest rates. The 10-year Treasury yields rallied from around 1.6% to over 2% in just a few weeks in May. As expectations for returns from yield go up, the price of the underlying investment paying that yield must either increase its payout or decrease in price. So, the XLU has decreased in price.
 
This makes sense as fixed income will decrease in price as rates rise. So the conundrum is clear: do we need to fear utilities the same way we fear fixed income positions right now?
 
I think the answer is a conditioned NO. I can make good arguments on either side here.
 
The case against: Interest rates will make comparisons more difficult for alternative yield products creating price pressure.
 
The case for: An increase in interest rates will only accompany an improving economy which means the Fed will taper which means the stock market will sell off – and Utilities are a defensive sector that investors use to seek cover.
 
Neither case is that compelling. However, the notion of any upside in the Utilities sector at a forward PE of 17x seems too optimistic.
 
So, to accommodate the ability to continue to hold the XLU, I think it is time to more aggressively sell the closer to the money calls on it. It’s a way to generate some extra income if, indeed, the declines continue.
 
I like the July $38 and $39 calls. Maybe 1/3rd in the $38 and 2/3rd in the $39 strikes. The blended premium for this strategy would be about a 1% return for 46 days – or around an 8% annual return.
 
Think about using this strategy to help position your portfolio against the inevitable decline caused by interest rates – or as a chance to sell out with Utilities still at a healthy price if they bump back up.


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